economic growth and convergence across the oic … · economic growth and convergence across the...

Economic Growth and Convergence across

the OIC Countries: An Econometric

Framework

OIC Outlook Series

May 2013

ORGANISATION OF ISLAMIC COOPERATION

STATISTICAL, ECONOMIC AND SOCIAL RESEARCH

AND TRAINING CENTRE FOR ISLAMIC COUNTRIES

SESRIC

Kudüs Caddesi No: 9, 06450 ORAN, Ankara, Turkey

Tel: +90-312-468 6172 Fax: +90-312-467 3458

E-mail: [email protected] Web: www.sesric.org

O R G A N I S A T I O N O F I S L A M I C C O O P E R A T I O N

STATISTICAL, ECONOMIC AND SOCIAL RESEARCH AND TRAINING CENTRE FOR ISLAMIC COUNTRIES (SESRIC)

OIC Outlook Series

Economic Growth and Convergence across the OIC

Countries: An Econometric Framework

May 2013

1

OIC Outlook | Current Stance of Energy

1. Introduction

There has been considerable empirical work on cross-country growth for the last two

decades. On the one hand, there were studies done on the basis of pre-existing models of growth in

the tradition of Solow (1956), Cass (1965), and Koopmans (1965) and, on the other hand, some others

were done along with the emergence of endogenous growth theories, including but not limited to,

Uzawa (1965), Romer (1986) and Lucas (1988).

The first group of economists claims that without conditioning on any other characteristics of

economies, the lower the initial level of real per capita gross domestic product (GDP) the higher is the

predicted growth rate. This is referred to as absolute convergence. The main idea is that poor countries

tend to grow faster per capita than rich ones. However, if the heterogeneity is allowed across the

economies, or to put it differently, if countries differ in various respects - propensities to save,

willingness to work, higher access to foreign markets- and if these respects are controlled for, then the

convergence applies only in a conditional sense. This concept is called conditional convergence meaning

convergence after differences in the steady states across countries are controlled for. The main idea is

that an economy grows faster, the further it is away from its own steady-state (long-run) value1 and,

hence, in looking for convergence in a cross-country framework, it is necessary to control for the

differences in steady-states of different countries (Islam, 1995).

1 Barro and Sala-i Martin (2004) defines steady-state as a situation in which the various quantities grow at constant (perhaps

zero) rates.

Contents Introduction

Data

Methodology

Absolute Convergence

Conditional Convergence under MRW Framework

Conditional Convergence and Determinants of Growth

Inclusion of Other Explanatory Variables and Re-Evaluation of Convergence Coefficient

Conclusion

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A more explicit formulation of the concept of conditional convergence is found in Mankiw,

Romer and Weil (1992), henceforth MRW, and this paper is based on that study, which is accepted as

a milestone for the empirical cross-country growth literature. In brief, MRW performed an empirical

evaluation of a Solow (1956) growth model using a multi-country dataset for the period 1960-1985.

They found support for the Solow model’s predictions by the inclusion of saving and population

growth rate variables in the regression. Furthermore, they considered an augmented version of the

Solow model by adding human capital as a factor of production, and ended up with strong evidence

for conditional convergence.

The main purpose of this paper is to investigate whether there is a tendency for regional

convergence among OIC countries2. The determinants of growth are also examined in this manner.

Such an analysis requires econometric framework for two reasons. First, econometric framework will

allow us to estimate to which extent the various explanatory variables (such as population,

investment, human capital, inflation and etc.) can affect the growth. Second, in order to analyze the

determinants of growth, graphical representation, alone, may be misleading. The relation can easily

be driven by a few outliers on the graph. It is, therefore, crucial to support graphical representation of

the data by econometric framework.

2. Data

Our sample comprises 31 OIC countries covering the period 1980-2009. Following the leading

studies in the literature, including but not limited to MRW, Bernanke and Gurkaynak (2001), the oil

producing OIC countries are excluded from the study, as the bulk of recorded GDP for these

countries represent extraction of existing resources (oil and gas). It is, therefore, not rational to expect

standard growth models to account for measured GDP in these countries3.

The per capita income and population data are taken from World Bank World Development

Indicators (WDI) dataset. The share of investment in GDP (investment ratio) and the inflation rate are

obtained from the International Monetary Fund (IMF) World Economic Outlook dataset. Secondary

enrolment rates including the female and male secondary schooling rates are obtained from United

Nations Educational, Scientific and Cultural Organization (UNESCO) dataset. Rule of law index is

obtained from World Bank Worldwide Governance Indicators. Finally, the share of intra-OIC exports

2 See Bagci (2012), for the existing income disparity among the OIC countries. 3 Bahrain, Gabon, Iran, Iraq, Kuwait, Oman, Saudi Arabia and United Arab Emirates are excluded on this basis.

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in total exports of countries is taken from Basic Social and Economic Indicators (BASEIND) database

of SESRIC.

3. Methodology

This study employs country-level data available for 31 OIC countries. Following MRW and

the other leading studies in the literature, income convergence in the OIC countries is estimated by

using ordinary least squares (OLS) method. For this purpose, two income convergence models are

employed: (i) Absolute Income Convergence; (ii) Conditional Income Convergence.

A univariate �-convergence model is estimated to determine if there is absolute convergence

over the sample period with the following equation:

�� ,��,�

� = + �� ,�� + � (1)

where is a constant, �� is a coefficient vector, �� denotes the average per capita income of country � in year �, �� is the natural logarithm, � − 1 is the initial year and � is the error term.

The conditional income convergence model is estimated as follows:

�� ,��,�

� = + ��,�� + μ��,�� + � (2)

where is a constant, �� is a coefficient vector, �� denotes the average per capita income of country � in year �, �� is the natural logarithm, � − 1 is the initial year,��,� indicates the explanatory variables,

μ� is a vector of μ� parameters, and � is the error term.

4. Absolute Convergence

The regression in the first column of Table 1 represents the results of the absolute

convergence model to determine if there has been absolute income convergence over the period

under consideration. Even though the convergence coefficient is negative (-0.002) and indicating

convergence of per capita incomes across the countries, it is statistically insignificant. The model is

also insignificant (Prob>F) and able to explain only 3 per cent of the total variation, which indicates

that growth may be conditional and convergence can be explained by incorporating other factors that

control for the differences in the long-run values. Indeed, this is not an unexpected outcome. As Barro

(1991) concludes the hypothesis that poor countries tend to grow faster than rich countries seems to

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be inconsistent with cross-country evidence, which indicates that per capita growth rates have little

correlation with the starting level of per capita product.

Table 1. Regression Results for Absolute and Conditional Convergence

Independent Variables

Log(GDP)-1980 -0.002

(0.94)

-0.005**

(2.58)

Log (Investment Ratio) 0.027***

(3.66)

Log (Population) -0.010*

(2.02)

Constant 0.025*

(1.68)

-0.029

(1.29)

Observations 31 30

R-squared 0.03 0.41

Absolute value of t-statistics in parentheses

*significant at 15% level; ** significant at 5% level; *** significant at 1% level

5. Conditional Convergence under MRW Framework

As pointed out above, an alternative formulation of the standard β-convergence model has

been to allow different economies to converge not to a common steady-state but to their own long-run

income relativities. Such a concept is called conditional convergence since the convergence is

conditional on the different structural characteristics of each economy such as propensities to save,

willingness to work, higher access to foreign markets, and etc. Different structural characteristics

imply that different countries will have different steady-state relative incomes.

The regression in the second column of Table 1, therefore, includes explanatory variables that

are also used in MRW’s paper. The explanatory variables added to the right hand-side of the

regression are the rates of investment and population growth. The coefficient on the initial level of

income is now significantly negative; that is, there is strong evidence of convergence. In addition, the

inclusion of the rate of investment and population growth improves substantially the fit of the

regression. The model now explains 41 per cent of the total variation.

For given values of investment and population growth rates, the neo-classical model predicts

a negative coefficient on initial GDP that enters in the system in logarithmic form. The coefficient on

the logarithm of initial GDP is interpreted as conditional rate of convergence. If investment and

population growth rates are held constant, or to put it differently, if countries did not vary in their

investment and population growth rates, then the economies tend to approach their long-run position

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indicated by the magnitude of the coefficient (Barro, 1996). The estimated coefficient of -0.005 is

highly significant and implies a conditional rate of convergence of 0.5 per cent per year. The rate of

convergence is very slow in the sense that it would take the economies more than 100 years to get half

way toward the long-run level of output. However, it should be noted that the inclusion of other

explanatory variables, in addition to investment and population growth rates, in the next section will

strengthen the tendency toward convergence.

6. Conditional Convergence and Determinants of Growth

Investment: Investment is a key element to economic growth. According to Blomstrom et al. (1993)

fast economic growth does not take place without large investments in fixed capital. Levine and

Renelt (1992) conclude that investment as a share of gross domestic product is the most robust

explanatory variable of a country’s growth. All in all, the empirical studies on growth indicate that

the rate of capital formation determines the rate of a country’s growth.

The estimated coefficient for the ratio of total investment to GDP is positive and statistically

significant, 0.024. It is clear from Table 2 that investment is the most important element in promoting

growth in OIC countries given the statistically significant and high coefficient value. OIC countries,

therefore, are urged to invest a substantial portion of their GDP to grow faster.

Human Capital: Education is considered as a major contributing factor to sustainable growth and

poverty alleviation. For this purpose, the measure of human capital will be added to the right hand-

side of the regression. Following the leading studies in the literature, human capital is proxied by the

log of the secondary school enrolment rate. The estimated equation is essentially same as that

estimated in MRW. A higher school enrolment indicates a higher accumulation of human capital.

Therefore, a higher enrolment rate may lead to higher economic growth, if higher human capital

means higher economic growth. First column of Table 2 reports the regression results. Inclusion of a

proxy for human capital further improved the fit of the model, particularly the significance level of

the negative coefficient of initial GDP compared to Table 1.

Notably, the results show a significantly positive effect of enrolment rate on growth. On

average, 1 per cent increase in secondary school enrolment rate is estimated to raise the growth rate

by almost 1 per cent per year.

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Furthermore, in order to analyze to which extent gender inequality in education may affect

growth, secondary school enrolment rate will be replaced by male secondary schooling and female

secondary schooling, respectively. As shown in the second column of Table 2, male secondary

schooling has a significant effect; the estimated coefficient is 0.011 which indicates that, on average, 1

per cent increase in male secondary schooling is estimated to raise the growth rate by 1.1 per cent per

year. Similarly, if the same approach is being employed for female schooling, then the estimated

coefficient of this variable is 0.01 representing that, 1 per cent increase in female secondary schooling

is estimated to raise the growth rate by 1 per cent per year.

Table 2. Regression Results for Conditional Convergence and Growth under MRW

Framework


Log(GDP)-1980 -0.008***

(3.53)

-0.009***

(3.40)

-0.011***

(3.78)

-0.010***

(3.78)


(3.39)

0.024***

(3.44)

0.022***

(3.16)

0.021***

(2.94)

Log (Population) -0.007

(1.36)

-0.006

(1.30)

-0.005

(0.95)

Log (Enrolment Rate) 0.008**

(2.20)

Log (Male-Enrolment Rate) 0.011**

(2.09)

Log (Female Enrolment Rate) 0.010**

(2.57)

0.010***

(2.91)

Constant -0.026

(1.26)

-0.036*

(1.67)

-0.014

(0.68)

-0.017

(0.79)

Observations 30 30 30 31

R-Squared 0.51 0.50 0.54 0.48



However, before concluding that female education is also a key factor to economic growth, it

should be noted that female education not only enables women to engage in healthier habits and

growing their children up in health ways but is also crucial to the reduction of fertility rates and, thus,

population growth (Dauda, 2013). It is, therefore, not surprising to expect that female education

would spur per capita income growth by lowering fertility, and this effect is not captured in

regressions showed in Table 2 as the fertility rate is already held constant. Thus, if the fertility rate,

which is proxied as the rate of population growth in this study, is omitted from the regression as

shown in the fourth column of Table 2, then the estimated coefficient on female schooling (the level of

female schooling that affects population growth inversely) is, again, 0.01 which implies strong

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evidence that female education enhances economic growth through only the indirect channel of

lowering fertility, which is in parallel to the findings of Barro (1996).

7. Inclusion of Other Explanatory Variables and Re-Evaluation of

Convergence Coefficient

Before proceeding to interpreting the effects of other variables on growth, the estimated

coefficient of rate of convergence will be re-evaluated since the regression includes more explanatory

variables. If countries in the sample did not vary in all these explanatory variables, the estimated

coefficient on the log of initial GDP is -0.013 that is highly significant (Table 3). It also implies a

conditional rate of convergence of 1.3 per cent per year. Despite the strength on tendency toward

convergence by the inclusion of more explanatory variables, it would still take economies almost 55

years to get half way toward steady-state level of output. Inclusion of all other variables increased R-

square; 72 per cent of the cross-country variation is explained.

Rule of Law: World Bank defines rule of law as a parameter that captures perceptions of the

extent to which agents have confidence in and abide by the rules of society, and in particular the

quality of contract enforcement -implying the institutional quality-, property rights, the police, and

the courts, as well as the likelihood of crime and violence. The rule of law index ranges from

approximately -2.5 (weak) to 2.5 (strong) governance performance. It has been stressed in the

literature that countries hold better governance performance will invest more which, in turn, lead to

higher growth rates. The rule of law variable, included in the regression reported in the first column

of Table 3, has a significantly positive coefficient, 0.007. It is evident that greater maintenance of the

rule of law is favorable to growth.

Intra-OIC Trade: The connection between trade and growth is still an open-ended question. While

some studies in the literature found a positive relationship between trade and growth, others doubt

the robustness of this impact. However, especially for the developing countries, trade is found to be

significantly and positively correlated with growth. More generally, trade volumes provide

substantial support for the hypothesis that trade promotes growth through a number of channels.

Trade variable in our study is measured by the ratio of intra-OIC exports plus intra-OIC

imports to GDP of each country in order to be able to analyze whether a higher increase in the intra-

OIC trade compared to overall trade level of the countries will lead to higher growth rates. The

8


results in Table 3 show a significantly positive coefficient on the terms of trade: 0.005 which implies

that an improvement in the terms of trade does stimulate an expansion of domestic output.

Table 3. Regression Results with the Other Explanatory Variables


Log(GDP)-1980 -0.013***

(5.38)

Log (Enrolment Rate) 0.003

(1.05)


(2.77)

Log (Population) -0.035***

(3.53)

Rule of Law Index 0.007*

(1.53)

Inflation 0.0001

(1.08)

Terms of trade 0.006**

(2.18)

Constant 0.074*

(1.99)

Observations 31

R-Squared 0.72



Inflation: Macroeconomic instability can cause damaging impacts on living standards. High

inflation, unsustainable debt levels, large swings in economic activity, and volatility in exchange rates

and financial markets can all contribute to job losses and increasing poverty and therefore lead to a

contraction in a country’s growth. Maintaining macroeconomic stability therefore is required for

sustained and inclusive development (UN, 2012). Inflation rate is the most common variable used as

an indicator of macroeconomic stability and it is usually found that inflation harms economic growth.

The inflation variable in our equation is the average rate of consumer prices during the

period under consideration. The estimated coefficient is not significantly different from zero. Thus,

there is only slight evidence that growth is negatively related with inflation in our sample.

8. Conclusion

This study investigated whether the OIC countries show a tendency for regional convergence

during the last three decade. The determinants of growth were also examined in this manner.

Considered together the results have several implications.

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First, the empirical findings of this study documents the existence of conditional convergence

which means that an economy grows faster; the further it is away from its own steady-state (long-

run) value. This phenomenon shows up clearly for the OIC countries from 1980 to 2009. Initially, the

convergence framework is examined under MRW framework. In this case, human capital is included

in the model and 50 per cent of the cross-country variation in income per capita is explained. The rate

of convergence is 0.5 per cent per year. Thereafter, more explanatory variables are included.

Employing new variables improved substantially the fit of the regression and 71 per cent of the total

variation was explained. In addition, it further lowered the coefficient on initial GDP and the rate of

conditional convergence was calculated as 1.3 per cent per year indicating that it would take OIC

economies almost 55 years to get half way toward steady-state (long-run) level of output. Such a

period is very long compared to the textbook Solow growth model4.

Second, in parallel with the findings of the previous empirical studies in the literature,

investment and human capital are the important determinants of growth for OIC countries as well.

Our results suggest that high investment rates and high levels of enrolment rate are directly growth

enhancing. However, female education enhances economic growth through only the indirect channel

of lowering fertility.

Third, the results conclude that a higher increase in the intra-OIC trade compared to overall

trade level of the countries appears to be growth-inducing. It is, therefore, important for member

countries to not only strive for higher trade but also push for strengthening trade relations among

them. In this context, the system of most-favored nation status can be adopted.

Fourth, the results indicate that the rate of growth of population is unfavorable to growth if

an equivalent portion of the economies’ investment is not used to provide capital for the new

workers. According to Becker and Barro (1988) another approach is that a higher rate of growth of

population will require the resources to be devoted to childrearing rather than producing of goods.

Last but not least, institutional quality is also an important element of economic growth. Our

results indicate that countries with better institutions and property rights grow faster. Therefore, OIC

countries are urged to give priority to improve the quality of their institutions which, in turn, will

enable them to invest more in physical and human capital and stimulate growth.

4 Such an outcome is not surprising and is in line with the previous empirical studies in the literature.

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SESRIC

Kudüs Caddesi No: 9, 06450 ORAN, Ankara, Turkey

Tel: +90-312-468 6172 Fax: +90-312-467 3458

E-mail: [email protected] Web: www.sesric.org

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